To meet ambitious goals for reducing greenhouse gas (GHG) emissions, many small projects (e.g. residential solar power installations) will be needed, in addition to large projects.

While these projects individually are too small to attract efficient financing via debt capital markets, they can be aggregated to create marketable debt securities.

To date, the approach has been adopted predominantly for individual projects in developed countries. Yet, nowhere is it more needed than in some developing countries that suffer from chronic shortages of funds.

Expansion of the approach to developing countries requires two credit enhancement measures. Firstly, the structure needs public sector support to help improve the credit standing of individual projects, with partial guarantees for instance. It is also essential to furnish investors with insurance to protect them against the risks that are typically more common in developing countries than in developed countries.

As the basis for further discussion, a prototype financial structure for covered green bonds for developing countries – the 'Prototype' – has been prepared. In common with the Environmental Finance article, the Prototype involves aggregating large numbers of small projects, with the aggregator meeting the financial needs of the individual projects, such as for loans and leases. The aggregator then issues green bonds backed by these assets it holds vis-à-vis the individual projects.

The Prototype also has, as an integral feature, public sector support for credit enhancement. The Prototype may be combined with Nationally Appropriate Mitigation Actions (NAMAs), but can also be promoted through other forms of blended finance. The central aim is to augment the flow of private sector funding for climate change activities in developing countries, allowing the public sector to concentrate on the areas beyond the private sector's capability. This is essential, given that the vast amounts of funds required for NDC implementation in developing countries cannot be met by the public sector alone.

Such covered green bonds will be denominated in a hard currency and are expected to be privately placed with one or a few institutional investors. They can be 'green notes' instead of 'green bonds', for the sake of regulatory and procedural simplicity. It should be clarified that the issuer's assets are offered as collateral in the traditional sense and will not involve securitisation that allows the issuer to move the assets to off-balance sheet status.

As well as assisting developing countries, the Prototype has the potential to provide green bond investors with investment opportunities with the following benefits:

definite information about the projects that have been financed with green bond investment;

precise data on the GHG mitigation contributions they make; and

no concern about additionality.

These benefits are elaborated below.

Before proceeding, a comment about the terminology will be relevant. In view of the description above, the proposed instrument could conceivably be referred to as 'asset-backed green bonds' or 'collateralised green bonds'. The concern about these designations is possible association with asset-backed securities (ABS) and collateralised debt obligations (CDO) that employed the securitisation technique and played major roles in the 2008 financial crisis (the Lehman shock), with the creation of various classes of securities and 'tranches'.

While it is acknowledged that the use of such terms as securitisation and ABS is increasingly acceptable for green bonds, and is understood to be different from their predecessors during the 2008 crisis, this article has opted to call the instrument a 'covered' bond.

An illustrative example

To clarify the concept, we have applied the Prototype to an illustrative example.(See Figure 1) Synthesised from several sources, and not representing a case that actually exists, the example relates to 872 installations of 20 kW solar PV systems at municipal government buildings (office buildings, schools, hospitals, etc.).

These PV systems, estimated to cost $42.3 million in total, are owned by an aggregator and provided to participating buildings under operating lease arrangements. To fund the total investment of $42.3 million, the financial plan is to rely on green bonds (or green notes) for 85% (i.e. $36.0 million), and on equity or grants for the remaining 15%.

Noteworthy feature

The Prototype's credit enhancement measures delineated below are such that they enable green bonds' participation from the inception of new climate mitigation activities, instead of being limited to refinancing. Thus, the green bonds in the Prototype structure are free from the often raised criticism about the lack of additionality (i.e. 'not creating anything new').

As mentioned earlier, the Prototype includes two credit enhancement measures to deal with real and/or perceived riskiness of individual projects in developing countries.

Guarantee by an international supporter

This is an outright guarantee to bond holders for loss arising from the failure of individual projects. The proposed levels of the guarantee are:

a) 100% for individual projects that are yet to attain the pre-agreed stabilisation criteria (as discussed below); and

b) 20% for individual projects that have reached the stabilisation criteria.

With respect to b), the proposed level is deemed sufficiently high for the illustrative example, given the performance reliability of solar PV facilities once stabilisation has been reached.

As regards the stabilisation criteria, the Prototype's proposal consists of:

the technology provider's written confirmation of successful installation;

a one-year history of uninterrupted smooth operation (except for regular maintenance), producing the planned level of electricity; and

a solid contract with the payer (electricity consumer, lessee, etc. depending on the project design) and one-year history of punctual payments.

Naturally, reasonable stabilisation criteria will vary according to project types. The Prototype provides a general framework, on the understanding that it will be modified on a project-specific basis.

Country risk insurance

The green bond investors will also receive protection, from an institution such as the Multilateral Investment Guarantee Agency (MIGA), against:

currency inconvertibility and transfer restriction;

expropriation; and

war, terrorism, and civil disturbance

Procedurally, this is likely to involve reimbursing green bond investors for the cost of the protection.

The insurance will not include protection against commercial risks. Such risks will be managed through collateralisation and guarantees.

GHG mitigation contributions

The Prototype mandates the issuer to report annually the GHG reductions delivered by the funded projects, after calculating them according to an internationally accepted method (e.g. the rules governing the Clean Development Mechanism).

For the illustrative example that requires $36.0 million of covered green bonds, its GHG mitigation contribution is estimated as 506.8 ktCO2e over its 20-year life, calculated according to the relevant CDM rules.

Potential

On a conservative assumption of annual green bond issuance of $100 billion, 1% of the issuance equals $1 billion per year. This is 27.8 times the amount of green bonds required for our example. Hence, the allocation of 1% of annual green bond issuance to undertakings similar to the illustrative example will theoretically enable each year the implementation of projects with an approximate total of 14.1 million tCO2e of GHG mitigation during their lifetimes (506.8 ktCO2e x 27.8).

While the calculation is admittedly an oversimplification, it does point to the huge potential GHG mitigation contributions that could be made by covered green bonds.

Next steps

Firstly, the Prototype needs to be revised based on the feedback to be received subsequent to this article. This will be followed by road-testing the revised Prototype, in cooperation with developing country project aggregators, public sector supporters and green bond investors. Readers' participation in these steps will be greatly appreciated.

Figure 1: Covered green bonds for developing countries

The diagram below represents the Prototype, including the credit enhancement measures, and shows how it is applied to the illustrative example with 872 individual projects (IPs).

It is noted that the diagram adopts an exact figure for the bond issuance to ensure that it can easily be identified as corresponding to 85% of the total investment costs. In practice, the amount will be rounded.

For the sake of simplicity, the AGGREGATOR is assumed to be the bond issuer, though the actual issuer may be some other entity in accordance with the host country's policies.

Costs and the replicability potential are tentative and will be confirmed as the first step of project implementation.

This value is based on the combination of actual values in a possible host country, international data, recent trends and assumptions considered reasonable.

The annual O&M costs are assumed to be USD 485.6, corresponding to 1% of the initial investment costs given in row (II).